I am trying to assist a relative with some tax strategies. They've done a great job accumulating, however they have pensions which fill up their tax buckets. They are trying to minimize income taxes and gift the money in case they have a long term care triggering event or something of that sort. They would rather their relatives get the money then an institution.

Their goal: Give a living inheritance to be able to watch loved ones enjoy the money.

Rough numbers
Emergency funds: Six months of expenses easily accessible
Debt: Mortgage on retirement house ($300,000) to be paid off after selling primary residence in NY
Tax Filing Status: MFJ
Tax Rate: 24% Federal, 6.65% NY State, (will retire in PA next year where tax rate is 3.07%)
State of Residence: NY for 2018, PA for 2019
Age: 65

Current retirement assets
His Military Pension- $45,000/year
His NY State Pension- $50,000/year
Her NY State Pension (starting in 2019)- $20,000 per year
Delaying SS until age 70

His 403b
$335,000 pre-tax

His Trad IRA #1
$100,000 80% pre-tax (and 20% non-deductible)

His Trad IRA #2
$50,000 pre-tax

His Roth IRA
$20,000

Her 403b
$305,000

Her Trad IRA
$50,000 pre-tax
Her Roth IRA
$20,000

They have concerns about a long-term care event wiping out their accumulated assets. They would prefer to gift $15,000 each annually to each of their 2 children ($60,000/ year) as a living inheritance. They watched a relative with substantial assets that needed LTC have their assets drained very quickly. They want to avoid that and give the money while living and healthy.

They asked if there is any strategy to remove the pre-tax money from the accounts between now and when they start taking SS at age 70 that would maximize their living inheritance and minimize taxes. Since the 24% tax bracket goes to $315,000, I thought about converting Trad to Roth up to the top of that bracket each year for the next 5 years so that they also avoid RMD's and have no pre-tax assets when SS kicks in. Then they could remove the money tax free from the Roth down the road.

If it were you and your goal was to give a living inheritance to be able to watch your loved ones enjoy the money, what would you do?

If I understand the numbers you presented correctly, this is their situation relative to Roth conversions.

2018 Adjusted gross income is 45K + 50K + dividends. (This may not be true if they worked this year. The 24% tax rate implied they did.)
If they did not and if both are age 65, standard deduction is $24,000 + 1,300 + 1,300 = $26,600.

Taxable income is $68,400. They could convert $9,000 to a Roth and remain in the 12% tax bracket in 2018.

2019 Adjusted gross income in 45K + 50K + 20K + dividends, or about $115,000.
Taxable income is about $89,000, about 12k into the 22% bracket.

Their pre tax saving are about $840,000. Their RMD's will be in the neighborhood of $30,000 to $40,000 per year the first few years (depending on how those assets do in the market over the next 5 years). Add in two SS Benefits and I don't see them getting too far into the 24% tax bracket level of $165,000 in income. Estimate: $115,000 + $30,000 + $50,000 = $195,000 adjusted gross or about $169,000 in taxable income.

My conclusion is that there is only a modest benefit in converting traditional to Roth if tax brackets remain at their current levels. They could run their numbers through a calculator ( i-orp or the Retiree Portfolio Model) and get a more exact estimate.

It does appear that 85% of their SS will be taxed regardless of its size at their marginal bracket.

Consider whether their pensions will continue for a surviving spouse before giving away too much of their assets. On the downside, a surviving spouse also is kicked into a higher tax bracket.

Not having lived in either NY or PA but from what I have read on this forum, they might want to establish residence in PA in a year prior to doing any conversions so as to avoid NY from claiming a chunk.

If I understand the numbers you presented correctly, this is their situation relative to Roth conversions.

2018 Adjusted gross income is 45K + 50K + dividends. (This may not be true if they worked this year. The 24% tax rate implied they did.)
If they did not and if both are age 65, standard deduction is $24,000 + 1,300 + 1,300 = $26,600.

Taxable income is $68,400. They could convert $9,000 to a Roth and remain in the 12% tax bracket in 2018.

2019 Adjusted gross income in 45K + 50K + 20K + dividends, or about $115,000.
Taxable income is about $89,000, about 12k into the 22% bracket.

Their pre tax saving are about $840,000. Their RMD's will be in the neighborhood of $30,000 to $40,000 per year the first few years (depending on how those assets do in the market over the next 5 years). Add in two SS Benefits and I don't see them getting too far into the 24% tax bracket level of $165,000 in income. Estimate: $115,000 + $30,000 + $50,000 = $195,000 adjusted gross or about $169,000 in taxable income.

My conclusion is that there is only a modest benefit in converting traditional to Roth if tax brackets remain at their current levels. They could run their numbers through a calculator ( i-orp or the Retiree Portfolio Model) and get a more exact estimate.

Thanks Peter, they both worked this year. He earned about $100k in 8 months before retiring in August and she will be around $50k for the year and retires in December. Next year they will both be on the pensions so then your numbers look good. And yes I was thinking converting before the tax act sunsets in 2026.

It does appear that 85% of their SS will be taxed regardless of its size at their marginal bracket.

Consider whether their pensions will continue for a surviving spouse before giving away too much of their assets. On the downside, a surviving spouse also is kicked into a higher tax bracket.

Not having lived in either NY or PA but from what I have read on this forum, they might want to establish residence in PA in a year prior to doing any conversions so as to avoid NY from claiming a chunk.

They should keep under the gifting "limits" which I believe are less than $15,000 per person (so I believe that should gift slightly less that $60,000). Doulbe check that.
Cody

Why? They will not be subject to estate taxes given the size of their portfolio.

Maybe I misunderstood the gift tax. So are you saying as long as they don't exceed the 11.2 million, someone could gift 10 million at once to one person and it would just reduce the lifetime exemption?

Since the 24% tax bracket goes to $315,000, I thought about converting Trad to Roth up to the top of that bracket each year for the next 5 years so that they also avoid RMD's and have no pre-tax assets when SS kicks in.

This isn't what you asked, but ...

Since they are age 65, are they on Medicare or will they be on Medicare after retirement? (I'm ignorant about whether the military and/or state government employment might give them options other than Medicare for retiree health insurance.)

If so, are you familiar with the Income Related Monthly Adjustment Amount (IRMAA) for Medicare Part B (doctor visits, outpatient, labs) and Part D (prescriptions)?

Item #1 to watch out for: IRMAA surcharges. Basically, premiums for Part B and D are determined by IRMAA income bracket. And any income amount anywhere near $315,000 (married filing jointly) would be in a high IRMAA bracket, which would mean $thousands more in annual Medicare premiums relative to the lowest IRMAA bracket (under $170,000 MFJ). IRMAA isn't an IRS tax, but it is determined by a modified version of the Adjusted Gross Income reported on the IRS 1040. If Roth conversions would cause additional IRMAA surcharges, it doesn't necessarily mean you shouldn't do the conversion, but you should be aware of the IRMAA surcharges before you do the conversion - and factor the IRMAA surcharges into your decision.

Item #2 to watch out for: collecting needed documentation at retirement so that you can appeal IRMAA surcharges. The social security administration uses the most recent IRS 1040 that is available to them, which is the one for 2 years previous. i.e. If your relatives file(d) for Medicare (part B and D) this year, it would be the 2016 IRS 1040. If they file next year, it would be the 2017 IRS 1040. Since they were still working those years, their income would be elevated, which might lead to IRMAA surcharges. But, retirement is a valid reason for appealing the IRMAA surcharge. They just would need to produce appropropriate documentation showing they had retired (but that might take some pre-planning to remember to ask for that documentation when they retire.)

Since the 24% tax bracket goes to $315,000, I thought about converting Trad to Roth up to the top of that bracket each year for the next 5 years so that they also avoid RMD's and have no pre-tax assets when SS kicks in.

This isn't what you asked, but ...

Since they are age 65, are they on Medicare or will they be on Medicare after retirement? (I'm ignorant about whether the military and/or state government employment might give them options other than Medicare for retiree health insurance.)

If so, are you familiar with the Income Related Monthly Adjustment Amount (IRMAA) for Medicare Part B (doctor visits, outpatient, labs) and Part D (prescriptions)?

Item #1 to watch out for: IRMAA surcharges. Basically, premiums for Part B and D are determined by IRMAA income bracket. And any income amount anywhere near $315,000 (married filing jointly) would be in a high IRMAA bracket, which would mean $thousands more in annual Medicare premiums relative to the lowest IRMAA bracket (under $170,000 MFJ). IRMAA isn't an IRS tax, but it is determined by a modified version of the Adjusted Gross Income reported on the IRS 1040. If Roth conversions would cause additional IRMAA surcharges, it doesn't necessarily mean you shouldn't do the conversion, but you should be aware of the IRMAA surcharges before you do the conversion - and factor the IRMAA surcharges into your decision.

Item #2 to watch out for: collecting needed documentation at retirement so that you can appeal IRMAA surcharges. The social security administration uses the most recent IRS 1040 that is available to them, which is the one for 2 years previous. i.e. If your relatives file(d) for Medicare (part B and D) this year, it would be the 2016 IRS 1040. If they file next year, it would be the 2017 IRS 1040. Since they were still working those years, their income would be elevated, which might lead to IRMAA surcharges. But, retirement is a valid reason for appealing the IRMAA surcharge. They just would need to produce appropropriate documentation showing they had retired (but that might take some pre-planning to remember to ask for that documentation when they retire.)

Up to $15,000 per year per recipient does not reduce the lifetime exemption.

Any amount over $15,000 reduces the lifetime exemption and requires filing form 709 with your tax return. However, there is no tax due until one exceeds the lifetime exemption.

Ah I understand now. So gifting exemption doesnt trigger reporting and does not count towards lifetime exemption. If exceeding the exemption it prompts reporting and deducting from the lifetime exemption.

They should keep under the gifting "limits" which I believe are less than $15,000 per person (so I believe that should gift slightly less that $60,000). Doulbe check that.
Cody

Why? They will not be subject to estate taxes given the size of their portfolio.

Maybe I misunderstood the gift tax. So are you saying as long as they don't exceed the 11.2 million, someone could gift 10 million at once to one person and it would just reduce the lifetime exemption?

That’s my understanding. The “gift tax” is just a way to keep track of whether you owe estate tax. But I’m not an American. Others might confirm?